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Crown Crafts (CWRS) Can Resist A Recession And Trades At Value Price


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Crown Crafts (NASDAQ:CRWS) is a designer of toddler products, including blankets, bibs and toys. The company outsources all of its products, mostly from China, and has no retail operations, with most sales concentrated in retailers like Wal-Mart or Amazon.

CRWS is a nimble company with only 130 employees, concentrated on design and sales. The company has used the outsourcing and wholesaling business model since the beginning of the 2000s.

Although CRWS has not been able to grow revenue in these two decades, it has improved its margins, by controlling CoGS and SG&A. It uses minimal debt to finance working capital, and has returned most cash to investors in the form of dividends.

CRWS’ competitive position is not fantastic. It faces bargaining risk from its retailers (Wal-Mart, Amazon) and licensors (Disney). The company is also exposed to sourcing risk from China. However, CRWS has operated in this environment for two decades without significant problems. In terms of cyclicality, its industry can suffer from lower consumption, but even during the Great Financial Crisis, CRWS’ sales and operating income did not suffer much.

In my opinion, with $6 per share as a limit, CRWS’ stock is an interesting opportunity for an long term investor interested in a steady dividend. With the stock trading well below its average historic P/E, it also represents an interesting capital gain opportunity.

Note: Unless otherwise stated, all information has been obtained from CRWS’ filings with the SEC.

Industry and competitive position

CRWS specializes in products for babies and toddlers. These include blankets, bibs and toys. This industry has some interesting characteristics.

First, it has the essential requirement for moat building, that is, there is no way for the end customer to compare two products on a rational basis. When the customer is purchasing a baby blanket or toy, he or she may perceive differences in quality but has no metric to actually check those differences. In that perception lies moat building.

Second, in most cases, end customer life is short. Most people only have one or two children during their life, usually close in age to each other, and in some cases the second child can receive objects from the first child. It is true however that people may have several nephews, nieces, grandchildren or friends’ children during their life, but even these situations are concentrated by generation. Most generations have kids at similar ages, and most parents become grandparents at similar ages. All this means that the relation between acquiring a customer and how much value can be extracted from the end customer is low.

Finally, the industry is definitely cyclical but has a defensive component, love for babies. People spend on their kids even in dire situations. If a family is in a tight spot, friends and family will become even more willing to spend on the kid. People can organize parties (baby showers) to help soon to become parents get the stuff they need. Although in difficult economic times people may decide to use other kids’ objects passed between friends or family, giving a present to new parents is almost a social mandate.

CRWS position in this industry is not as a manufacturer nor as a retailer. In a certain way, it is not even a brand builder completely. Rather, the company is a middle-man, sourcing from China, licensing from companies like Disney and wholesaling to retailers like Wal-Mart. One could argue that CRWS is a relationship builder, and that its most precious assets are the relationships it cultivates, particularly with manufacturing sources and with retailers.

This positioning makes some sense. If the end customer’s lifetime value is low, then it makes no sense to spend a lot on acquiring the customer from CRWS’ perspective. Rather, it may be more beneficial to bond with a retailer that can extract much higher value from that relationship.

Retailer relationships are vital for CRWS. According to the company’s FY22 (calendar 2021) 10-K report, 52% of its sales come from Wal-Mart and another 21% from Amazon. These add up to 73% in only two customers. Although the company does not disclose further, one might imagine that Target occupies another portion of the remaining 27%.

This has been part of CRWS’ model for decades. The FY15 10-K report cites Wal-Mart and Toys R Us holding 61% of revenue. These two companies plus Target generated 71% of revenues in 2003.

The relationship between retailer and supplier is twofold. In general, the retailer has the upper hand, because it controls the demand source. However, the retailer also needs a reliable source of products that can provide quantity and quality. That means that the retailer has more power in the negotiation, but that the supplier can also tend to the relationship in order to keep or increase shelf space. For example, CRWC mentions that one of its sales offices is in Bentonville, Arkansas, population 55 thousand, but home of Wal-Mart’s headquarters.

In a similar vein to wholesaling instead of retailing, CRWC has leveraged other brands to help them acquire the customer. Instead of trying to build a brand in advance of people having kids, CRWC can use brands that are already associated with kids. For FY22, 40% of revenues came from licensed products, 33% of which were licensed from Disney. Again, the model was used in 2015, when Disney represented 44% of sales, and in 2003, when Disney represented 30% of sales.

These licenses are expensive. In FY22 CRWS paid $6 million in royalties for $35 million in revenue (40% of FY22’s $87 million), or 17% of its wholesale price. But again, they help generate more sales, and if those sales are profitable then the company is better off. Just like with retailers, the licensor has the upper hand in bargaining but also benefits from having a trustworthy partner that can generate recurrent royalties and that will not damage the brand.

The relationship with Disney is so vital to CRWS that the CEO of NoJo, CRWS’ main brand, was the president of Soft Products North America for Disney for 5 years.

Finally there are CRWS’ suppliers. The company closed all of its directly controlled manufacturing at the beginning of the 2000s. Since then, the company has been outsourcing, mostly from China. In my opinion, this represents the greatest competitive risk for CRWS. Because retailer relationships are so vital, CRWS risks losing shelf space if it finds itself trapped in supply-chain bottlenecks. A search among CRWS’ earning presentations transcripts bears no mention of China’s recent COVID related supply-chain bottlenecks. There is also no mention on the company’s documents of plans to relocate part of production to other Asian economies, like Vietnam, to fight Chinese labor cost increases and regulatory risks.

Cost structure and operating history

Given that CRWS does not manufacture and has no retail operations, its structure is relatively nimble. The company only has 130 employees, dedicated to product design (or selection maybe) and sales.

Since it adopted its outsource everything business model, CRWS revenues have not grown at all. However, the company has been able to post higher margins, both at the gross and at the operating level. This is a signal that the company can control costs, which is the main determinant of profitability for industries where the company does not have a significant moat.

The chart below shows that CRWS has some operational leverage, albeit not substantial, but most importantly, that margins have trended upwards.

Chart
Data by YCharts

In terms of cyclicality, CRWS shows what we commented in terms of baby and toddler products being somewhat protected from cycles. Although there have been variations both at the revenue and the operating income level, those are not enormous. The difference between peak and valley sales in a cycle is $20 million, and the difference in operating income is $4 million. Also, the company’s operating profits have essentially never dropped below $6 million, not even in the midst of the Great Financial Crisis.

Chart
Data by YCharts

Financing and capital allocation

An important aspect providing CRWS with a margin of safety is its lack of long term debt.

The company does make use of a $26 million credit facility yielding SOFR +1.5% maturing in 2025, but only for working capital purposes. The facility is repaid in the same operating cycle.

Chart
Data by YCharts

It is true that this exposes CRWS to cycle risks, for example if it is unable to sell all of its inventory. CRWS’ cash-cycle is not short, taking almost half a year. The quarterly data below also shows recent problems collocating inventory.

Chart
Data by YCharts

Another portion of operations is financed with cash generated by CRWS. The company’s CFO before working capital has usually been above operating income. The reasons are non-cash compensation to managers, and depreciation that has been substantially higher than fixed investments.

Chart
Data by YCharts

CRWS has also paid substantial dividends. Since 2012, the dividend payout ratio has never been below 60%, averaging $0.32 per share. On occasions, CRWS has been aggressive to maintain its dividend, going above 100% payout ratio. Although a lower dividend might reinforce the company’s cash position, returning wealth to shareholders helps avoiding management misallocation of capital.

Chart
Data by YCharts

Going forward

In its most recent report, for 1Q23 (May to July 2022), CRWS reported a slight decline in comparable revenues on a YoY basis. After adjusting for comparability, the fall in revenues stands at 10%.

However, the company also showed a recovery in margins, generating more gross profits than on 1Q22, with lower revenues. After adjusting for one-time charges to SG&A in 1Q22, 1Q23 shows a 10% increase in SG&A costs, in line with inflation.

According to CRWS’ management, the situation is not ideal. Its customers are still holding onto inventory and delaying new purchases, and end customers are moving to lower priced items. We have seen those effects on CRWS’ longer cash-cycle. According to CRWS’ CEO, inventories and revenues should recover by 3Q23 (January 2023).

But even in that context, and without resorting to accounting magic, the company was able to generate $1.5 million in net income in the quarter. Annualized, that figure would reach $6 million, yielding earnings of 10% compared to the company’s market cap of $60 million.

Not only that, but CRWS is exposed to seasonality, with the first quarter being the worst in terms of both sales and income, as can be seen in the chart below. This means that CRWS could still cross the $6 million net income mark. Management has provided no guidance about this issue.

Chart
Data by YCharts

For a catastrophic scenario though, I refer to the Great Financial Crisis, when the company’s operating income essentially bottomed at $6 million. At an effective tax rate of 25%, that would represent $4.5 million in net income, for the worst economic crisis seen in nearly a century.

Multiple recovery and volume

I do not usually care about multiples because I take a long-term investor view. The basis for my investment thesis is that the business can generate sufficient returns on the price paid, independently of what the stock price does after investing.

However, in this case, after covering the business opportunity, and considering it interesting, I also add the multiple opportunity. The chart below shows that CRWS’ operating income is at all time highs on a TTM basis, but that its P/E ratio is close to minimums.

Chart
Data by YCharts

Finally, the company’s stock is relatively thinly traded. Its yearly average volume has been 17 thousand shares per day, or just about $102 thousand. It may become difficult to build a position, and also to exit.

Chart
Data by YCharts

Conclusions

CRWS is a company that has opened a niche in a competitive but also relatively defensive market. Without a sufficiently long operating history, its business model would be considered too risky. The company depends too much on specific relations (retailers, licensors, manufacturers).

However, CRWS has operated this business model for 20 years successfully, even in the worst of the crisis. It has not managed to grow revenue but has been able to increase its margins, without using debt. Although its dividend policy seems aggressive at times, it has also avoided bad capital allocation decisions.

Taking the good and the bad into account, CRWS does not seem excessively priced. 1Q23 (July 2022) data shows that the company should be able to obtain $6 million in net income for FY23, against a current market cap of $60 million. Without debt and without significant operating leverage, a negative scenario promises $4 million in net income. This was already tested during the Great Financial Crisis.

On top of the business based margin of safety, the company is being valued at a historically low P/E ratio. This provides additional protection and the possibility of enjoying capital gains from P/E multiple recovery in a more positive financial context.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.



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